Cash Flow Hedges Combinations of Options Involving One
Written Option and Two Purchased Options

Cash Flow Hedges: Combinations of Options Involving One
Written Option and Two Purchased Options

Derivatives Implementation Group

Statement 133 Implementation Issue No. G15

Title:

Cash Flow Hedges:
Combinations of Options Involving One Written Option and Two
Purchased Options

Paragraph
references:

29

Date cleared by
Board:

December 6, 2000

QUESTION

For a hedging relationship in which a combination of
options (deemed to be a net purchased option) is designated as the
hedging instrument and the effectiveness of the hedge is assessed
based only on changes in intrinsic value of the combination of
options, may the assessment of effectiveness be based only on
changes in the underlying that cause a change in the intrinsic
value of the hedging instrument (the combination of options)? In
other words, may the assessment of effectiveness exclude ranges of
changes in the underlying for which there is no change in the
hedging instrument's intrinsic value? Specifically, is the example
hedging relationship illustrated in the Background section
involving a combination of options considered effective at
offsetting the change in cash flows due to foreign currency
exchange rate movements related to the forecasted transaction?

BACKGROUND

JPN is a Japanese subsidiary of a U.S. company. JPN's
functional currency is the Japanese Yen. JPN has forecasted
inventory purchases to be paid in U.S. dollars (USD). As a result,
JPN is exposed to changes in the Yen-USD exchange rate: its
functional currency cash outflows will increase (loss) if the Yen
weakens versus the USD and decrease (gain) if the Yen strengthens
versus the USD. JPN would like to hedge the foreign currency
exposure related to the forecasted transaction by entering into a
combination of foreign-currency-denominated option contracts
designated as a single hedging instrument. For purposes of this
discussion, it is assumed that JPN has met the qualifying criteria
regarding forecasted transactions eligible for designation as
hedged transactions pursuant to paragraph 29 of Statement 133 and
that the options are entered into contemporaneously with the same
counterparty and can be transferred independently of each other.
Also, assume that the combination of foreign currency option
contracts meets all of the conditions in Statement 133
Implementation Issue No. E2, "Combinations of Options," to be
considered a net purchased option (that is, considered not to be a
net written option subject to the requirements of paragraph
28(c)).

JPN employs the following hedging strategy:

The forecasted transaction is estimated at
$150,000,000. The at-the-money forward rate is 120 Yen per USD
(¥120/USD1).

JPN's documented hedge objective is to offset
the foreign exchange risk to the functional currency equivalent
cash flows at levels above ¥125/USD1 and in the range from
¥113/USD1 to ¥108/USD1. In the range ¥113/USD1 to
¥125/USD1 and at levels below ¥108/USD1, JPN chooses not to
offset the foreign exchange risk to the functional currency
equivalent cash flows.

To implement this hedge objective, JPN enters
into the following option contracts and jointly designates them as
the hedging instrument:

One purchased option that gives JPN the right to purchase
$150,000,000 at an exchange rate of ¥125/USD1. Premium paid:
$1,536,885.

One sold (written) option that, if exercised, obligates JPN to
purchase $150,000,000 at an exchange rate of ¥113/USD1. Premium
received: $1,536,885.

One purchased option that gives JPN the right to sell
$150,000,000 at an exchange rate of ¥108/USD1. Premium paid:
$737,705.

The time value of the combination of options is to be
excluded from the assessment of effectiveness and, therefore,
effectiveness is based only on changes in intrinsic value related
to the combination of options.

The purpose of Option 1 is to protect JPN when the
Yen-USD exchange rate increases above ¥125/USD1. As the Yen-USD
exchange rate increases, JPN will be required to purchase the
$150,000,000 inventory at a greater Yen-equivalent cost. As the
Yen-USD exchange rate increases above ¥125/USD1, the intrinsic
value of the option increases as the option is increasingly
in-the-money. That increase in the option's intrinsic value is
expected to offset the increase in the Yen-equivalent expenditure
on the forecasted transaction.

JPN also writes an option (Option 2) that obligates
JPN to purchase USD from the counterparty at an exchange rate of
¥113/USD1. The counterparty will exercise the option whenever
the Yen-USD exchange rate is below ¥113/USD1. As the Yen-USD
exchange rate decreases, JPN will be required to purchase the
$150,000,000 inventory at a lesser Yen-equivalent cost. As the
Yen-USD exchange rate decreases below ¥113/USD1, JPN's losses
related to increases in the intrinsic value of the written option
are expected to offset the decrease in the Yen-equivalent
expenditure on the forecasted transaction.

JPN also purchases an option to sell USD (Option 3)
for a notional amount equal to the notional of the written option
(Option 2) with a strike price of ¥108/USD1. JPN will exercise
Option 3 whenever the Yen-USD exchange rate is below ¥108/USD1.
When the exchange rate is below ¥108/USD1, although JPN will be
obligated to make payment in relation to Option 2, it will also
receive a payment in relation to Option 3. As a result of
purchasing Option 3, JPN will be exposed to exchange rate
fluctuations on Option 2 only when the exchange rate is between
¥113/USD1 and ¥108/USD1. Hence, with Options 2 and 3, JPN
has effectively limited its hedge offset to changes in cash flows
on the forecasted item to levels between ¥113/USD1 and
¥108/USD1. Changes in the exchange rate below ¥108/USD1
result in no change in the intrinsic value of the combination of
options because the change in Option 2 offsets the change in Option
3. However, when the exchange rate is below ¥108/USD1, the
combination of options has an intrinsic value other than zero.

In summary, potential changes in intrinsic value
related to this combination option hedge construct (Options 1, 2
and 3) would limit the hedge offset to corresponding changes in
functional currency cash flows on the forecasted transaction only
at levels above ¥125/USD1 and in the range ¥108/USD1 to
¥113/USD1, consistent with JPN's documented hedge
objective.

RESPONSE

Yes. In a hedging relationship in which a combination
of options (deemed to be a net purchased option) is designated as
the hedging instrument and the effectiveness of the hedge is
assessed based only on changes in intrinsic value of the hedging
instrument (the combination of options), the assessment of
effectiveness may be based only on changes in the underlying that
cause a change in the intrinsic value of the hedging instrument
(the combination of options). Thus, the assessment can exclude
ranges of changes in the underlying for which there is no change in
the hedging instrument's intrinsic value.

The example cash flow hedging relationship
illustrated in the Background section involving a combination of
options may be considered effective at offsetting the change in
cash flows due to foreign currency exchange rate movements related
to the forecasted transaction. Specifically, JPN may assess the
effectiveness of the hedge based only on changes in the underlying
that cause a change in the intrinsic value of the combination of
options. Thus, in that case, JPN would assess effectiveness of the
hedge only when the Yen-USD exchange rate is above ¥125/USD1
and between ¥113/USD1 and ¥108/USD1. Likewise, JPN's
assessment would exclude changes in the Yen-USD exchange rate
between ¥113/USD1 and ¥125/USD1 and below
¥108/USD1.

The combination of options used by JPN as a hedging
instrument is deemed to be a net purchased option based on the
provisions in Statement 133 and the guidance in Implementation
Issue E2. Therefore, the hedging relationship avoids being subject
to the special hedge effectiveness test for written options in
paragraph 28(c). In particular, as it relates to Condition 1 of
Implementation Issue E2, the aggregate premium (that is, the time
values) for the three options comprising the hedging instrument
results in JPN paying a net premium. The evaluation of whether a
net premium has been received (Implementation Issue E2, Condition
1) must include consideration of only the time value components of
the options designated as the hedging instrument. That evaluation
must not include the intrinsic value, if any, of the options.

The above response has been authored by the FASB
staff and represents the staff's views, although the Board has
discussed the above response at a public meeting and chosen not to
object to dissemination of that response. Official positions of the
FASB are determined only after extensive due process and
deliberation.